The Pharmaceutical Journal Vol 267 No 7170 p560-561 20 October 2001

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Articles

Choose the best legal format for running your business

By John McQueen, BA

The final article in our business focus series this year looks recent developments in business law which could affect all those running a small or medium-sized enterprise The incorrect choice of the legal format for a new business can have far-reaching consequences should the business subsequently fail. The author discusses the commonly used formats, including the new limited liability partnership Business focus series

Choosing the best legal format for a business is probably the most important choice to be made by anyone setting up a new venture. All too often, this aspect is overlooked by entrepreneurs who do not envisage their ideas failing. Anyone already in business should take the time to review what can be a critically important matter. It is essential that the correct legal format is in place before it is too late to rectify any mistakes. Although this may not apply strictly to pharmacies, an analysis of current statistics shows that most new businesses do not survive beyond the first three years of trading. Many close because of debts and some become heavily insolvent. It is at this point that the correct choice of legal format can save the owners from personal financial liabilities. There are several legal formats for running of business. The three most common are partnership, sole trader and a limited company. Each has its pros and cons. The partnership Unfortunately, over the years, the Bankruptcy Association has dealt with hundreds of cases where accountants have advised sole traders to take in wives or husbands as partners. Usually this advice is based on supposed tax savings for the partner. Many couples have found themselves both bankrupt, with the loss of the family home and all their combined assets, as a consequence of choosing the wrong legal format. Each partner is liable for all the debts of any partnership. This can be risky if one partner goes off the rails or makes poor business decisions. If things go financially wrong then creditors can claim against all the partners for the debt. Worryingly, creditors can alternatively claim all the debt off one partner alone. People who leave a partnership can also find that later, if the business fails, they are still liable for its debts. Many accountants would probably advise the use of this format without looking ahead at potentially disastrous outcomes should a business fail. This advice is based on possible, short-term, tax advantages gained by each partner. At best, the tax advantages are marginal, and it is debatable that there are any at all. In any event, they are no fair exchange for the hugely increased personal risks that are involved by bringing in multiple partners. People may point to the successful use of partnership formats for solicitors and doctors’ practices. Indeed, most of these are run successfully. This is only because they are normally in a strong financial position and are carefully managed by senior partners. These partnerships are the exception to the rule, not the norm. Partnerships are usually dangerous. The limited liability partnership This partnership format, which came into force on 6 April this year, may be the answer to the problems caused by normal partnership arrangements when a business fails (see Panel). In the case of a limited liability partnership, it is the business, and not the individual, that has liability to third parties. There are provisions, however, that make a negligent partner personally liable for all the debts. Its usefulness remains to be tested. The sole trader This is the most common of the three formats and often the most sensible, especially for someone setting up a new business. Sole traders are individuals. They are personally liable for the debts of that business. If a sole trader is married then a spouse cannot be held liable for any of the business debts. The advantage of being a sole trader is that it is a simple and clear format and tax matters are relatively easy to deal with. Anyone running or thinking of setting up a business involving little risk of financial loss should adopt this legal format. Risk takers A word of caution is needed for sole traders with businesses that involve real financial risks. They should be aware of their position should things go wrong. A small builder with a large overdraft to finance building work is in considerable danger. If a sole trader is in this position and has a bankruptcy order made against him, then he may lose his interest in any jointly owned property, ie, the family home. It is still surprising how many spouses think their home is safe in the event of a partner’s bankruptcy. It is not until a trustee in bankruptcy forces the sale of jointly owned property, to realise the bankrupt’s interest in it, that this misconception becomes all too tragically apparent. Anyone intending to go into business and take risks should ensure that the matrimonial home is in a partner or spouse’s name from the outset. A trader already in business who has overlooked this matter may gift his or her share of the home to a spouse. However, certain conditions have to be observed to ensure that this transaction is safe from being overturned in a court of law. If a person is solvent when the gift of property to a spouse or partner is made, the property will be safe if a bankruptcy petition is not made within two years. If a person is insolvent when the home is gifted to the spouse or partner then five years must pass from the date of the gift without a bankruptcy petition being made for any property to be safe. Observance of these conditions ensures that the home will be safe during any future bankruptcy proceedings. It is, therefore, possible to take precautions to ensure the security of the family home. Considering that it is the loss of the family home which causes a bankrupt and his family the most distress, it is surprising how many people do not ensure that it is made safe. Limited companies This is the most sensible format for an intended larger business. Arguably, it is also a better alternative to a partnership business. Limited companies are responsible for their own debts. They are a separate legal entity from the individuals who own or run them. On the provision that credit is only obtained for the limited company then the personal assets of those who run it cannot generally be touched if the company becomes insolvent. Run sensibly this is the ideal format for a risk-taking enterprise. In practice, many directors find themselves with a wide range of financial difficulties when a limited company fails. Those running a limited company should ensure that they are fully aware of their responsibilities and liabilities should things go wrong. Directors may be liable to the liquidator of their company if they have taken borrowings from the company loan account. The tax advantages for directors drawing loans instead of wages can backfire if a company fails. In addition, banks and other financial institutions commonly ask directors to give personal guarantees on loans to the company. Such guarantees in effect negate the limited liability benefits of a limited company. If the company cannot pay these guaranteed debts then the homes and personal assets of the directors who signed such guarantees are at risk. Directors of limited companies, however, who are well informed and who run their business sensibly can hugely reduce any personal financial risks by using this format. Entrepreneurs should choose the correct format for their particular business based on an informed understanding of the law. Running a business is a dangerous game, the consequences of which can be catastrophic. It is wise to be well prepared.

The limited liability partnership: how does it work? The new limited liability partnership came into force on 6 April 2001. In the case of a limited liability partnership, it is the business and not the individual that has a legal liability to third parties, much like a limited company. It is important to note, however, that there are provisions that make a negligent partner personally liable and, if found liable, personal assets will be at risk as in a normal partnership arrangement. Setting up There are no requirements for potential members of a limited liability partnership to enter into formal written agreements between themselves. The requirement to register the partnership with the Registrar of Companies should prompt any well-advised potential partners to enter into formal agreements before the business starts trading. All limited liability partnerships must be registered. To do this there must be a minimum of two people in the partnership. Each partner must endorse an incorporation document to be delivered to the Registrar of Companies. This document will contain details about the business and the partners. It will include the address and location of the business and the names and addresses of the people who are to be members of the partnership on incorporation. Each member will then be able to conduct business as an agent of the limited liability partnership. The trading name of the partnership must have the suffix Limited Liability Partnership (LLP). Business safeguards The limited liability partnership will, in the normal course of business, be bound by the actions of its agents, ie, the members. Importantly, the business will have some protection from a rogue member. If the other agents can prove that he or she acted without the authority of the partnership then the business will not be held liable for a rogue member’s actions. Notification of changes When a member wishes to leave a limited liability partnership the registrar must be notified within two weeks. A member who changes his address must notify the registrar within three weeks. Members of the partnership would be well advised to ensure that the registrar receives notification that a member has left well before the end of the notification date. This is important because, even though the person is no longer a member, he or she may still carry out transactions under the name of the partnership. These transactions will still be valid unless the partnership can prove that the third party involved knew that the person being dealt with was no longer a member. No doubt, in most circumstances, this would be extremely difficult. The business would not be held liable if the registrar had received notification that the member had left the partnership. Taxation The new format is subject to the same taxation rules as a traditional partnership, with the important protection of limited liability should the business fail. Therefore, the tax benefits of a limited liability partnership would seem to be the same as for a traditional partnership. A key point to bear in mind at this juncture is one that has been proved time and time again with the limited company format. Often directors of these companies will put up personal assets, such as their homes, or give written personal guarantees as security for loans. Usually this is upon the insistence of the banks to secure lending. This effectively negates the limited liability and leaves the individual dangerously vulnerable should the business fail. People contemplating a limited liability partnership would do well to bear this in mind when considering their finance options. Changing legal format Existing partnerships changing their legal format to the new limited liability partnership format will not be considered to have stopped trading for tax purposes if they meet certain requirements. For tax purposes, a traditional partnership changing to the new format will be considered as a traditional partnership-to-partnership transfer. This reasoning will also be applied to the transfer of assets between a traditional partnership and a limited liability partnership. Insolvency The insolvency provisions for limited liability partnerships are set by the Secretary of State for Trade and Industry. Major procedures such as receivership, administration, voluntary and compulsory winding up will all be applied with, it must be noted, “adaptations necessary to suit limited liability partnerships”. Baroness Buscombe, Shadow Minister for the Lord Chancellor’s Department, said when the new format was being debated in the House of Lords: “My heart goes out to anyone who might wish to form an LLP without the benefit of extensive advice.” Wise words.

Mr McQueen is founder and chief executive of the Bankruptcy Association (tel 01524 64305, website www.theba.org.uk)

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